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The Emergence of Forward Guidance As a Monetary Policy Tool

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Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. The Emergence of Forward Guidance As a Monetary Policy Tool Edward Nelson 2021-033 Please cite this paper as: Nelson, Edward (2021). \The Emergence of Forward Guidance As a Monetary Policy Tool," Finance and Economics Discussion Series 2021-033. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2021.033. NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers. The Emergence of Forward Guidance As a Monetary Policy Tool Edward Nelson* Federal Reserve Board May 7, 2021 Abstract Forward guidance—the issuance by a central bank of public statements concerning the likely future settings of its policy instruments—is widely regarded as a new tool of monetary policy. The analysis in this paper shows that Federal Reserve policymakers from the 1950s onward actually accepted the premises of forward guidance: the notion that longer-term interest rates are key yields in aggregate spending decisions; and the proposition that indications of intentions regarding future short-term interest rate policy can affect longer-term rates. Over the same period, they were nevertheless wary about providing forward guidance regarding short-term interest rates, fearing that this could generate untoward market reactions or lock the Federal Open Market Committee into inappropriate rate settings. They concentrated on describing future policy in terms of achievement of economic objectives, with their commentary on interest-rate prospects usually confined to consideration of the longer-term factors affecting rates. Even in these years, however, there were infrequent occasions—notably in 1974 and 1982—when policymakers provided more explicit guidance regarding the path of short-term rates. In the 1990s, a consensus developed in U.S. policy circles that was more receptive toward the notion of guiding longer-term interest rates by providing indications of future FOMC actions. This consensus developed even before concerns about the lower bound on short-term rates became prevalent in U.S. policymaking. The new mindset, which stressed the stabilizing effects on the economy of communication of policy intentions, set the stage for the emergence of forward guidance as a monetary policy tool. Key Words: Forward guidance, monetary policy tools, monetary policy strategy, interest-rate forecasts, interest-rate lower bound, Federal Open Market Committee, Federal Reserve. JEL classification numbers: E43; E58. * Email: [email protected]. The author is grateful to Ben Bernanke, David López-Salido, Jón Steinsson, and Lars Svensson for comments on an earlier draft. The author has sole responsibility for any errors. The views expressed here are the author’s alone and should not be interpreted as those of the Federal Reserve or the Board of Governors. 1. Introduction “[I]t is true there are no adjectives, no judgments and no explanations of present actions or inaction in these [Federal Reserve] statements and reports; nor are there tips, predictions, threats or promises of future action. Nor, given our present state of knowledge, does it seem desirable or appropriate that there should be.”—George W. Mitchell, Federal Reserve Board governor, October 19661 “[I]nfluencing the public’s expectations about future policy actions became a critical tool…”— Ben S. Bernanke, Federal Reserve chair, October 20112 Forward guidance—the issuance by a central bank of public statements concerning the likely future settings of its policy instruments—is now a key aspect of monetary policy in the United States. The study of the properties and implications of forward guidance has also developed into a vibrant part of the research literature on monetary policy and its effects. Even before forward guidance became an entrenched component of U.S. monetary policy announcements, Eggertsson and Woodford (2003) had provided a formal analysis showing that public undertakings to adhere to an expansionary stance for a stretch of time might serve as a means by which the monetary authorities could stimulate aggregate demand when their short-term nominal interest-rate instrument was currently at its zero or effective lower bound (ELB).3 In the realm of monetary policy practice, limited moves toward the inclusion of forward guidance in the Federal Open Market Committee’s (FOMC) postmeeting policy statements occurred in 2003and2004. The regular incorporation of forward guidance into FOMC postmeeting statements began in 2008, when the federal funds rate moved to its ELB. The FOMC’s deployment of forward guidance regarding the federal funds rate has continued—with many variations being made in the specific form of guidance provided—in the years since 2008, both in and outside ELB conditions.4 The practical experience established through the employment of forward guidance by monetary policy committees in the United States and other countries has, in turn, had a major influence on —————————————————————————————————————————— 1 Mitchell (1966a, p. 3; p. 398 of 1971 printed version). See also Mitchell (1966b, p. 8). 2 Bernanke (2011, p. 4). 3 Prior to this, Tobin (1981, pp. 206207) and Krugman (1998, esp. pp. 162, 179180), among others, had pointed toward a policymaker commitment to generating, or validating, inflation in future periods as a method by which a central bank could stimulate aggregate demand in ELB conditions. In contrast, however, to Eggertsson and Woodford (as well as Woodford, 1999), and also unlike much of the twenty-first-century literature on forward guidance, Tobin and Krugman did not consider in detail what such an articulation of desired outcomes might imply for the formulation of the central bank’s reaction function. 4 See, for example, Clarida (2020). 1 the analytical work that has been done on this policy measure. The research in question has included efforts to develop classification schemes regarding different types of forward guidance (for example, Campbell, Evans, Fisher, and Justiniano, 2012); to ascertain the empirical effect of forward guidance on U.S. longer-term interest rates (for example, Swanson and Williams, 2014); to bring out cases, in quantitative forward-looking models, in which forward guidance might either generate outsized effects on economic activity (for example, Del Negro, Giannoni, and Patterson, 2015, and McKay, Nakamura, and Steinsson, 2016) or have notable limitations in its ability to stimulate aggregate demand (for example, Levin, López-Salido, Nelson, and Yun, 2010; Campbell, Ferroni, Fisher, and Melosi, 2019; García-Schmidt and Woodford, 2019; Cole, 2020); and to analyze how forward guidance fits alongside other policy tools—including, most notably, central-bank purchases of longer-term government securities—into the formulation of a cohesive monetary policy strategy, especially in a situation in which the policy rate is at the ELB (for example, Engen, Laubach, and Reifschneider, 2015; Svensson, 2015; Bernanke, 2020; Eberly, Stock, and Wright, 2020). A perspective on forward guidance that is largely common to these research contributions is encapsulated in Bernanke’s (2020) grouping of forward guidance among the “new tools of monetary policy.” The analysis in the present paper departs from the existing literature in focusing on U.S. monetary policy in the pre-2003 period from the perspective of forward guidance. In doing so, this paper fleshes out the grounds on which forward guidance should be considered a new tool. At the same time, however, the analysis in this paper offers evidence that, in key respects, this perception warrants considerable reevaluation. The essential concept of forward guidance is, as documented below, of long standing and was familiar to the policymakers of past eras. This fact is brought out in this paper via an analytical account covering the relevant developments in U.S. monetary policy discourse over the five decades to 2003. The examination concerns Federal Reserve policymaker statements, actions, and discussions that anticipated and prefigured—as well as those that criticized and rejected—the option of employing the monetary policy tool that would become known as forward guidance.5 —————————————————————————————————————————— 5 Because the paper is concerned with public communications, the documentary material examined in this paper consists primarily of Federal Reserve officials’ on-the-record statements (such as those given in speeches and congressional testimony) rather than material (like FOMC meeting transcripts) that was disclosed only after a multi- year lag. Some internal material is considered, in order to provide a check on the reliability (as an authentic account of the views held by those in policy circles) of what was relayed in the public statements. 2 In particular, this paper traces the emergence of forward guidance as a policy tool in the United States by highlighting the evolving perspectives, expressed by successive Federal Reserve policymakers, toward presenting formal or informal public
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